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Choosing the Right Benchmarks for Your Mutual Fund

Prepared by: Financial Planning Association

Key Points

What Are Investment Benchmarks?

What’s in a Name?

Money Market Funds

Bond Funds

Equity Funds

Commonly Used Benchmarks

Apples to Apples

Consider Appropriate Time Frames

Benchmarks Should Be Resources — Not Deciding Factors

Points to Remember

Community school boards use standardized tests to gauge how their students perform in relation to national averages. On an even more basic level, your local weather forecasters can check the accuracy of their predictions by measuring temperatures and rainfall. As a mutual fund investor, you also have tools available to gauge the performance of your investments. Such tools are known as market benchmarks. The challenge, however, is choosing the tool that most accurately serves your purpose.

What Are Investment Benchmarks?

The dictionary defines a benchmark as “a point of reference for measurement.” Market benchmarks are used by individual investors, portfolio managers, and market researchers to determine how a particular market or market sector performs. Often cited in news reports, market indexes can be especially helpful to mutual fund investors by offering market “standards” to help them evaluate the risk and the return history of their own investments. However, investors should remember to compare their mutual fund to the index that best tracks securities comparable to the fund’s holdings, and to use an appropriate time frame.

What’s in a Name?

The appropriate index for your needs is not always easily identified by its name or popularity. For example, most people have heard of the Dow Jones Industrial Average, since its closing figures are quoted nightly on news broadcasts. However, many people may not be aware that the Dow tracks only 30 stocks of some of America’s largest companies — not a very reliable source for comparison if your fund’s holdings include small-capitalization or international companies.

To help you determine which index may be appropriate for your needs, following are descriptions of some of the more popular indexes, separated into mutual fund categories.

Money Market Funds1

Bond Funds

Barclays Aggregate Bond Index: A combination of several bond indexes, Barclays indexes are among the most widely used benchmarks of bond market total returns.

10-Year U.S. Treasury Bond: The yield on this long-term U.S. government bond is often looked to as the standard bond yield for long-term bond investments.

Equity Funds

Standard & Poor’s Composite Index of 500 Stocks (S&P 500): A broad-based, unmanaged measurement of the average performance of 500 widely held industrial, transportation, financial, and utility stocks. Many people believe that this, among the most often cited indexes, includes the 500 largest stocks on the New York Stock Exchange. Not true: In fact, it includes the stocks of companies that are or have been leaders in their respective industries and that are listed in the New York Stock Exchange and the NASDAQ Market System. The industry weightings in the S&P 500 are selected to reflect the components of gross domestic product.

The Nasdaq Composite Index: This large index (over 2,500 issues) was created in 1971 to measure all common stocks that are traded in the Nasdaq market.

Morgan Stanley Capital International’s Europe, Australasia, Far East (EAFE) Index: The most prominent of the indexes that track international stock markets, the EAFE is composed of companies considered representative of 21 European and Pacific Basin countries.

In addition to the above, other indexes are: the Value Line Composite Index (stocks); the Russell 2000 Index (small-cap stocks); the Citi-3-Month T-bill (money markets); the Dow Jones World Stock Market Index (major international markets, including the U.S. market); and the Barclays Global Aggregate Bond Index (global bond index).

Commonly Used Benchmarks

To compare…

You might refer to…

Money Market Funds

IBC’s Money Fund Report Averages

Barclays 3-Month Treasury Bills index

Bond Funds

Barclays Aggregate Bond Index

10-Year U.S. Treasury Bond

Equity Funds

S&P 500 Index

Nasdaq Index

MSCI EAFE Index

Apples to Apples

As noted earlier, the key to navigating the maze of benchmarks is to know which one best tracks securities similar to the holdings in your fund. But remember that you don’t have to be an experienced market researcher to find out which benchmark is for you. Most mutual fund prospectuses, annual reports, and SAIs (statements of additional information) list the comparable index, usually right in the “investment objective” section. Often, a fund that tracks more than one sector or asset class may list more than one index to reference. For example, a balanced fund may reference both the Barclays Bond Index and the S&P 500 to measure its bond and stock holdings, respectively. Finding the right index is yet one more example of why it’s so important to read a prospectus carefully before investing in a fund.

Consider Appropriate Time Frames2

When evaluating a mutual fund in relation to its benchmark, remember to consider performance over a period of time that is similar to your investment time frame. This chart shows annualized returns for three popular benchmarks.

Benchmarks Should Be Resources — Not Deciding FactorsThough benchmark indexes are not actively managed or available for investment purposes, some funds actually hold the same securities that are in the index (or otherwise strive to replicate the index returns). Known as index funds, these funds are managed with a “passive” style: The fund manager only needs to monitor the holdings in the benchmark index and make adjustments in the fund accordingly. Generally, the objective of an index fund is merely to maintain performance standards similar to the index that it tracks, whereas other funds often seek to outperform their benchmark indexes. Index funds often offer lower management fees because of their passive management style.

While indexes are good methods of gauging how a mutual fund performs in relation to the overall market, they shouldn’t be the deciding factor in determining if a fund may meet your needs and objectives. When evaluating a fund, ask yourself the following questions:

Does the fund’s objective seek to meet your investment needs?

How long will your money be invested in the fund? Though past performance cannot guarantee future results, consider the performance record of the fund over a similar time frame.

How well can you withstand fluctuations in the value of your investment over time?

The benchmark listed in your fund’s prospectus will give you a good idea of what to expect from your mutual fund. However, remember that standardized tests are just that — standardized. They are not meant to represent individuals and their needs and financial circumstances. Your investment representative can help you evaluate an investment in terms of your personal objectives and risk tolerance and can also show you how to use a benchmark index in the most effective way.

Points to Remember

An investment benchmark is a tool used by investors and portfolio managers to gauge how an investment performed in relation to the overall market.

The appropriate index for your mutual fund investing needs is not easily identified by its name or popularity level.

Remember to compare “apples to apples”: choose the benchmark that most accurately reflects the holdings in your mutual fund.

Most prospectuses, annual reports, and SAIs list the benchmark(s) most appropriate for your mutual fund.

Benchmark indexes are not managed and do not reflect trading costs or fees, and investors cannot invest in them.

Index funds sometimes offer investors close to market returns and seek to maintain performance standards similar to the indexes they track.

Use benchmarks merely as resources, not deciding factors, when evaluating a mutual fund.

Research mutual funds with your investment advisor, who can show you how to use benchmarks in the most effective manner.

Source/Disclaimer:

1An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although most funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a fund.

2The performance of any index is not indicative of the performance of any particular investment. Keep in mind that indexes do not take into account any fees and expenses of the individual investments that they track and that individuals cannot invest directly in any index. Past performance is no indication of future results. Investors in international securities are sometimes subject to somewhat higher taxation and higher currency risk, as well as less liquidity, compared with investors in domestic securities.

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